Although likely not the intent of In re Siag Aerisyn, LLC, a recent decision from the United States Bankruptcy Court for the Eastern District of Tennessee Southern Division, some might argue that the opinion serves as a how-to guide for masking a capital contribution by an affiliate as a loan constituting bona fide debt. As the defendant SSAB Enterprises, LLC, became keenly aware, whether an advance is characterized as debt or equity can affect a debtor’s solvency and trigger the application of certain provisions in the Bankruptcy Code—say, section 547(b), for example.
During the 90-day period prior to Siag Aerisyn LLC’s bankruptcy filing, the debtor paid SSAB approximately $2.6 million for materials SSAB supplied the debtor to construct wind towers. After the filing, the debtor initiated an adversary proceeding against SSAB to avoid the transfers pursuant to section 547(b) of the Bankruptcy Code. Under section 547(b), a trustee may avoid any transfer of an interest of the debtor in property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before the transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the date of the debtor’s bankruptcy filing; and (5) that enables such creditor to receive more than the creditor would receive if the transfer had not been made and the debtor’s bankruptcy were a chapter 7 case. The only issue in this case, however, was whether the debtor was insolvent when it made the transfers to SSAB.
The court never actually answered the insolvency question. This is because the court first had to rule on SSAB’s motion for partial summary judgment as to whether an advance the debtor received from one of its affiliates constituted a loan (debt) or a capital contribution (equity).
During the two years prior to the debtor’s bankruptcy filing, the debtor received approximately $11.5 million in advances from an affiliate. In its schedules, the debtor listed a claim owed to its affiliate in the amount of approximately $9.9 million as an “advance from parent.” As of the petition date, the debtor had made two repayments on the advance, totaling approximately $2.4 million.
SSAB contended that section 547(b) did not apply because the debtor was solvent at the time the debtor made the transfers to SSAB. Under SSAB’s theory, the debtor was solvent because the advance from the debtor’s parent was actually an equity investment and not a loan. SSAB relied on the Sixth Circuit decision in In re AutoStyle Plastics, Inc. to support its position that the $9.9 million should be recharacterized as equity.
11 Steps to Recharacterization
In AutoStyle, the Sixth Circuit held that a bankruptcy court has the power to recharacterize a claim for debt as equity because it is vested with equitable powers to assess the validity of debts. Using Roth Steel Tube Co, v. Comm’r of Internal Revenue as a guide, the Sixth Circuit developed an eleven-part test (yes, 11!) for determining whether a court should recharacterize debt as equity. The factors include (1) the names given to instruments evidencing the indebtedness, (2) the presence of a fixed maturity date and schedule of payments, (3) the presence of a fixed rate of interest and interest payments, (4) the source of repayments, (5) the adequacy of capitalization, (6) the identity of interest between the creditor and the stockholder, (7) the security for the advance, (8) the corporation’s ability to obtain financing from outside lending institutions, (9) the extent to which an advance was subordinated to the claims of outside creditors, (10) the extent to which an advance was used to acquire capital assets, and (11) the presence of a sinking fund to provide repayments. No one factor controls, and a fact-specific inquiry must be conducted for each factor in each case. Generally, the more a transaction looks like it arose out of an arm’s length negotiation, the more likely a court will treat the transaction as debt.
Here’s how the debtor scored (for the purpose of partial summary judgment):
(1) The Names Given to Instruments Evidencing Indebtedness
The absence of notes or other instruments of indebtedness raises suspicion that an advance was a capital contribution and not a loan. In Siag Aerisyn, the trustee provided a copy of the note evidencing the parent’s advance to the debtor. Also evidencing the loan were corporate meeting minutes and a unanimous written consent signed by the debtor’s board of managers. SSAB challenged this evidence, arguing that the failure to create the note prior to the first advances and the debtor’s failure to classify the note as a promissory note rather than an advance in the debtor’s schedules indicated the note was an equity investment in disguise. The parent also never filed a proof of claim.
Though the court agreed that several facts raised doubt as to whether the note was truly a “note,” the court held that the existence of the note itself established genuine issues of fact.
(2) The Presence of a Fixed Maturity Date and Schedule of Payments
An advance without a fixed maturity date and fixed obligation to repay looks a lot more like an equity investment than a loan. The note in this case was a demand note, a type of note that typically does not have a fixed maturity date or repayment schedule. This factor weighed in favor of SSAB’s position.
(3) The Presence of a Fixed Rate of Interest and Interest Payments
A loan without a fixed interest rate and interest payments is probably too good to be true. The demand note included a provision for interest. Despite the debtor’s general ledger documenting monthly interest accruals, the debtor never made any interest payments on the advance.
The presence of an interest rate and the calculation of interest, however, were enough for the court to decide that this factor weighed against partial summary judgment that the advance was an equity contribution.
(4) The Source of Repayments
If the expectation of repayment solely depends on the success of the borrower’s business, the transaction bears a strong resemblance to a capital contribution. As noted, the debtor made two substantial repayments on the advance. The debtor’s former Vice President and CFO, however, testified that the parties understood that the debtor would make periodic repayments only if and when its cash receipts from sales allowed and only after the debtor had paid its vendors. The court found the evidence regarding this factor mixed and, therefore, weighed against partial summary judgment.
(5) The Adequacy of Capitalization
An advance to an undercapitalized borrower signals that the advance was an equity investment. The debtor’s former Vice President and CFO testified that he considered the debtor to be substantially undercapitalized and believed the advances were necessary to operate the debtor’s business. There also was evidence that another affiliate of the debtor provided the debtor with an initial investment of $5 million upon its inception and that the debtor had a net income of approximately $2.2 million during the first months of its operation. Because of conflicting evidence, the court found that genuine issues of material fact existed as to whether the debtor was undercapitalized at its inception.
(6) The Identity of Interest between the Creditor and the Stockholder
The more proportionate a stockholder’s advance is to the stockholder’s ownership in the borrower, the more likely the advance was intended to be a capital contribution. On the other hand, a sharply disproportionate ratio between a stockholder’s percentage interest in stock and debt is indicative of bona fide debt. The Siag Aerisyn court found it unclear whether the parent’s advance to the debtor was in proportion to its equity interest in the debtor. The debtor’s operating agreement and other testimony suggested that the parent was not an owner of the debtor. The demand note, however, stated that the parent, through its subsidiary, owned a 70% equity interest in the debtor.
(7) The Security for the Advance
The absence of security for an advance suggests an equity contribution. The demand note indicated that the advance was unsecured.
(8) The Corporation’s Ability to Obtain Financing from Outside Lending Institutions
WWRCD (what would a reasonable creditor do)? If the answer is a reasonable creditor would not act in the same manner as an affiliate that advanced money to the borrower, this factor probably favors recharacterization. Evidence suggested that the debtor would have struggled to obtain funding from an outside lending institution. There was no evidence that the debtor tried to obtain alternative financing. Despite finding that this factor weighed in favor of recharacterization, the court noted that this factor was not dispositive because it is often that struggling companies only are able to obtain loans from their affiliates.
(9) The Extent to Which the Advance Was Subordinated to the Claims of Outside Creditors
An advance that is last in line behind the claims of all other creditors raises doubt as to whether the advance is a true loan. The court found this factor neutral. At the time the parent made the advance to the debtor, the debtor was struggling to pay any creditors. Even though the debtor made two repayments on the advance, the parties also understood that the debtor only would do so after the debtor paid its vendors.
(10) The Extent to Which the Advance Was Used to Acquire Capital Assets
When a borrower uses an advance to meet its daily operating needs, rather than to purchase capital assets, the advance looks more like bona fide debt. In this case, the debtor needed and used the advance to fund its daily operations.
(11) The Presence of a Sinking Fund to Provide Repayments
The lack of a sinking fund for repayment signals that an advance was a capital contribution and not a loan. An accountant testified that demand notes usually are not accompanied by a repayment schedule or a sinking fund because demand notes usually are paid with earnings. This factor also weighed against partial summary judgment.
In case you’re not done tallying the score, the debtor came out on top. True, the court simply concluded that there were genuine issues of material fact as to whether the debtor and its parent intended the advance to be a loan or a capital contribution. It is quite possible a more fact-intensive inquiry will compel the court to recharacterize the $9.9 million as equity. The fate of the debtor’s preference action remains to be determined. What makes this case interesting, however, is how it could affect other debtors and other cases. Although Siag Aerisyn walks through the ways to assess the validity of a claim of debt, in so doing, the opinion may also provide a manual for how to better cloak a capital contribution in the characteristics of a bona fide loan.
Sometimes there is a thin line between equity and “debt.”